One of the key sources of funding for American shale is evaporating, just as the the sector needs it more than ever.
Banks lending against the oil and natural gas reserves of hundreds of independent U.S. drilling companies have pulled back from the sector at an unprecedented rate this year after energy prices slumped.
There’s every indication they’re not done: Many in the industry expect further reductions to credit facilities in the fall, with higher costs and more stringent protections for lenders.
All that comes at a time that could scarcely be more challenging for shale. Weakened by poor returns to shareholders, it was getting shut out of the bond and equity markets even before the COVID-19 pandemic decimated global demand.
With crude prices staging a limited recovery in the last two months to around US$40 a barrel, shale operators face an uncertain future, one where they must to drill to generate cash flow while facing a higher cost of capital.
“As long as oil prices stay at US$40 or less and gas stays at US$2 or less, I think banks are going to continue to be very cautious and continue to pull back,” said Spencer Cutter, an analyst at Bloomberg Intelligence. “It’ll be the end of shale if oil stays below US$40.”
Shale lending doesn’t just involve banking behemoths like JPMorgan Chase & Co. and Wells Fargo & Co. but smaller regional entities such as BOK Financial Corp., Cadence BanCorp and Amegy Bank NA. Shale companies negotiate their credit lines in spring and again in fall.
Any adjustments are typically modest, but banks slashed many loans this spring. According to S&P Global Ratings, borrowing bases, which are determined by the collateral value of oil and gas reserves, were reduced by an average of 23 per cent. Credit commitments were lowered by 15 per cent on average.
Shale drillers Chaparral Energy Inc. and Oasis Petroleum Inc. saw some of the severest cuts this spring on a percentage basis, with borrowing bases reduced by 46 per cent and 53 per cent respectively. Closely held Bruin E&P Partners LLC and Jonah Energy LLC saw their commitments cut below the actual amount drawn, requiring them to repay the deficit within six months. Bruin filed for bankruptcy last week.
It’s not just the shrinking of loans that should concern drillers. They’ve become pricier, too, by about 50 basis points over Libor, and the leverage limit for credit lines has come down to around 3.5 times earnings, compared with the previous average multiple of four times earnings for the industry, according to people familiar with the recent loan reviews who asked not be identified since those discussions were private.
Banks have also reintroduced anti-cash hoarding measures to stop borrowers withdrawing large amounts of money from credit facilities and then holding on to it, according to one of the people.
That’s designed to thwart a tactic sometimes used by companies of drawing down a loan just before a bankruptcy filing. Some shale companies are doing better than others.
WPX Energy Inc. is among those that hedged some production and are expected to eke out a profit for the second quarter despite depressed energy prices. Oil and gas could still rise again if the global recovery gains momentum, providing a get-out-of-jail card for shale drillers.
But for operators with higher costs and interest payments, the current price environment looks extremely tough-going. A total of 27 U.S. energy companies have filed for bankruptcy through July 20, according to data compiled by Bloomberg. Many of them are shale operators, with Chesapeake Energy Corp., Whiting Petroleum Corp. and Ultra Petroleum Corp. among the most notable names.
For the banks, it’s a balancing act: They need to manage their exposure to the sector, but if they cut credit lines too severely the borrowers may default. Amid such a broad economic downturn, they’re pulling back across the board, not just in energy. Last week, as the biggest U.S. lenders reported second-quarter earnings, Wells Fargo disclosed a 12 per cent decline in loans outstanding to oil, gas and pipeline companies. JPMorgan said that of the US$111 million in net charge-offs it took in the quarter, an indication of the amount the bank doesn’t expect to be repaid, 87 per cent was related to the exploration and production sector.
Among smaller lenders to the shale patch, Tulsa-based BOK said Wednesday that potential problem loans totaled US$626 million at the end of June, more than double the total three months earlier, largely attributable to energy.
The worst outcome for a bank is being forced to mark down the value of a loan or taking ownership of assets used as collateral. Already some are taking losses on energy-related debt, something almost unheard of during previous downturns, said Jeff Nichols, a partner at law firm Haynes & Boone LLP.
That’s marked out one difference between this downturn and that of 2015-2016, when unsecured creditors absorbed losses but most senior lenders were spared. For example, in the case of Mesquite Energy Inc., which emerged from bankruptcy in May, its value had shrunk so dramatically that even its bankruptcy loan -- typically the most secure part of the capital structure -- ended up being impaired.
Lenders in the sector have been making preparations in anticipation that they’ll end up becoming the so-called “fulcrum” security in a restructuring, meaning their debt could end up converting to equity, or they could end up owning assets, according to David Baggett, managing partner at Opportune LLP, a firm that advises oil and gas companies through bankruptcy.
Because banks aren’t typically in the business of running oil companies, those options could include hiring a third-party manager to operate the assets. Some lenders are already figuring out how to do that just that, according to Baggett.
“More banks are going to be taking haircuts,” he said. “A third of the banks doing upstream energy lending will no longer be doing that in the next couple of years.”